Will my PCs be arrested for openly displaying magic items in the city-states?
However, even if the PCs are careful with displaying their magic items, there is always the elf or rogue that may catch a glimpse of the magic item (Perception) and relieve the PC's of their item.
I always have a local NPC rogue that will hassle the PCs if they get too open with their purses, metal, or magic weapons... They will occasionally lose items in the elven market or have them stolen by a rogue!!
As long as the magic item could masquerade as a psionic item you could be safe unless you really bring the attention of the templars on you. Orbs and Staffs are used by Psions but Wands are the tools of the arcane. Luckily you can hide them up your sleeve
Just because an Item is enchanted, does not mean it is arcane.
Psions also gain use of the Ritual Caster feat, and have access to Transfer Enchantment, Disenchant Magic Item and Enchant Magic Item Rituals. Psionically enchanted items existed in 2E, and they can exist in 4E.
That being said, openly displaying any sort of power in the streets of any City State is likely to draw lots of unwanted attention. It doesn't matter if that display of power is from a magical item, a spell, an exploit or a discipline. If that display of power causes any sort of disturbance of the peace, you can bet the Templars are going to be looking into it. If your power will not be brought to heel under the Sorcerer King, it will be taken from you or you will be destroyed.
Will my PCs be arrested for openly displaying magic items in the city-states?
If your players show they have wealth (as "adventurers" often do) while having no social standing whatsoever ("adventurers" often have no social standing given they're mercenary vagabonds) then they're ripe for a templar to hassle them. All they need is something the templar wants from them (either wants them to do something or wants something they have). If you're players have the backing of a noble house or a merchant house, or are part of a powerful criminal organisation, then they're more likely to be allowed magic items. If they don't have any backing whatsoever, then they're likely to be hassled by a templar.
That said my post doesn't answer the question of whether magic items are illegal. To be honest its largely irrelevant. The templars can enforce laws or not enforce them as they wish. They can also make up arbitrary and non-existant laws on the spot.
It is far more important in a Dark Sun campaign to have a patron then in any other campaign, simply so the players can have some measure of protection.
Adventurers, on the other end - non-noblemen, but possibly tough-looking - will get official punishment (public beating, most likely) if they refuse to pay a fine to let it slide. If ash and incantations were involved, they're in trouble, for only the king's templars (defilers) can wield arcane magic.
People won't see the difference between item powers and character powers anyway.
The reason I asked is because I have the old 2nd edition DS book "Dune Trader", and there it implies that magical items are considered illegal contraband in the city-states. Not having either of the original boxed sets, I wanted a clarification. (It didn't mention the status of psionic items.) I wasn't refering to the actual use of the items in a city, just simple possession.
The answer I give (and I use in my game) is that magic items are conspicuous displays of wealth and power in a land of scarcity where the strong rule. They aren't illegal but you display them openly at your own risk. As long as you can demonstrate that you are strong enough to keep them, you are fine.